A Red Winter
“We are not seeking revolution. We just want democracy.” – Joshua Wong, Hong Kong student activist
Though volatility is still hitting the markets, not much has really changed in the economic landscape since our last newsletter. The U.S. is plodding along at a 2.5% – 3% annualized real rate of growth, Britain is still exiting (sometime, somehow), and trade issues continue to be on the minds of many. On the political side, however, a new event has added to the mosaic. The protests in Hong Kong we see today have the potential to impact the global economy.
The protests that have been taking over the city—almost one-third of the population came out to protest—are driven by a proposed new extradition law that would make it much easier for China to extradite individuals back to the mainland. Since the handover of Hong Kong to China in 1997, the city has lived under a “one country, two systems” mode of operation that was to extend into 2047. The two systems consist of one that respected the rule of law and the other that respected the desires of the communist party.
Through this proposed extradition legislation, the Hong Kong political leadership—widely assumed to be operating with instructions from leadership in Beijing—was taking an early step towards merging the Hong Kong legal system with China’s, causing significant distrust and fear among current residents.
Watching the protests build over the past few weeks has been awe-inspiring. The city last saw significant protesting in 2014, when Beijing tried to exert more control over the region. Like last time, though, it appears that the power of the people will be heard and obeyed, for now. Bravo.
Although the withdrawn Hong Kong legislation addressed extradition, of equal importance, was less publicized language in the bill that would have allowed Beijing to freeze the Hong Kong assets of people suspected of breaking Chinese law. This exposes all of Hong Kong to the whims of China’s rulers. In response, wealthy people with money in Hong Kong have been moving funds out of Hong Kong.
Consider this: Hong Kong is home to more than 800 individuals with a net wealth of greater than $100 million. How many of them do you think will sit idly by as China threatens their wealth and freedom? Overnight interest rates – used by banks to fund dollar needs – can shed light on the question.
When the demand for money becomes higher than the supply readily available, it will show itself in short-term rates jumping above the rates of longer-term instruments. An analogy would be people leaving a theater. If time was not the primary concern, the exit will have a comfortable flow of individuals. In the event of a fire, the demand to exit will be much greater. Interest rates work the same way. Looking at Hong Kong’s jump in short-term overnight interest rates, we suspect the very wealthy are moving their assets out of the city, free from grasps of China’s rulers.
We think the U.S.-China trade issues, the Muslim concentration camps in Xinjiang, and the rising discontent in Hong Kong are the results of a deviation in China’s path. As we have mentioned in prior commentary and on our webinar discussing the trade war, President Xi has been moving away from free-market principles instituted under Deng Xiaoping and towards policies that have more in common with Mao Zedong, prioritizing the preservation of the communist party over the needs of the population.
Though we spend most of our time discussing investment markets, we cannot avoid how political uprisings in other countries affect the global economy. We suspect China’s new, more authoritarian path will be a continued theme, unfortunately, with unpredictable and lasting impact on global money movement, trade, and the world economy.
We discussed in our last newsletter that supply chains are not static, and it would not take much time to lessen the U.S.’s dependence on Chinese exports. The chart below demonstrates how this happened already in the first quarter. With their economy driven by exports, this will no doubt prolong the slowing they are currently experiencing.
In our past writings, we opined that China’s asset/debt bubble reminded us of Japan’s problems in the 1980s. The bust of Japan’s asset bubble started around 1990 exposing the fragility of their economy. It took over 25 years to recover resulting in Japan losing its status as the second-largest economy. We thought the similarity with China – another economy that grew quickly through an export-led model – was fitting as China is now experiencing large debt expansion and softening growth. Our premise was that any disruption to their economy would be mostly contained within their borders, as was experienced during Japan’s correction. However, the analogy may not be the best.
We have been reading Hassan Malik’s Banks and Bolsheviks about the largest debt default in modern times, in Russia in 1918. We are starting to adjust our thinking on China as a result. At the turn of the 20th century, Russia was a promising economic story with industrialization taking hold and significant external investment in its infrastructure. In the first 20 years of the century, Russia experienced a growing level of external debt and a slowing of prosperity amongst its population. It eventually culminated in the removal of the tsar and the rise of the communist party; a group that eventually defaulted on the debts built under the tsar. It was argued that the debts taken on by the prior government were not the responsibility of the new government or the people of Russia. Keep that in the back of your mind for a minute.
The large buildup of debt, rapid growth in the economy and the dependence on exports drove our thoughts around likening China’s eventual bust to that of Japan. However, Malik’s book has highlighted a different potential ending. There is a large difference between Japan and China in its political framework and the fragility of its government. Japan is relatively free with a loyal citizenry and strongly allied with the U.S and Europe. China, not so much. In China, the communist party represents about 80 million people or less than 8% of the population. The large debts incurred have, in part, been households buying real estate but much more sits within local governments and state-owned enterprises (we are increasingly hearing them referred to as ‘party-owned enterprises’). They were the doing of the ruling party rather than the population at large.
We are starting to think the level of distrust of China’s leadership by its citizens and by major economic powers around the globe has a non-zero probability of being disruptive in an ongoing manner. We are seeing material weakness across many consumer goods (e.g., auto sales are down more than 15% from last year; air conditioners sold are down more than 10%.) We fear that the large growth in household debt in China, as shown in the graph above, combined with an increasing fear of export weakness, will impact spending and consumer confidence, even more, going forward. And with that, the pressure will build for the government to respond to a growing level of discontent within its population. How they handle that discontent will define the future of China and the communist party.
This is the characteristic that drives us to think more of Russia’s asset bubble versus Japan’s. We are not as confident in China’s ability to refinance more than $1 trillion (dollar-denominated) debt this year. As tensions rise and distrust builds, the risk increases that China may need to rely on less traditional means. We are seeing stresses build within their banking system. Since our last newsletter of only a month ago, we have seen their government take over a mid-sized bank in Mongolia which is leading to a ripple effect among other lower quality banks. A growing number of smaller banks are late in producing current financial statements (similar to the Mongolian bank) and experiencing rapidly higher funding rates. Not the sign of robustness. We have also seen the bankruptcy of one of the largest real estate developers and growing debt defaults from firms that showed large cash balances just a few months ago. This all signals to us a growing economic instability on a fragile political foundation.
To say there are economic crosscurrents would be an understatement for what is happening globally. We believe that any country’s economic health is influenced by three factors: monetary, political, and fiscal policies. Though central banks around the globe are pushing hard on easing monetary policy to aid the economy, the political disruptions and the resulting uncertainty are taking their toll. Language from central banks and their impact on short term interest rates can, and have, caused exuberance within the stock market. But other, more fundamental factors are signally a fragile outlook. Which leads us to our current defensive positioning of 20-30% cash levels across client portfolios.
Our signals are mixed at this time and have resulted in our portfolio being defensively positioned yet still maintaining some exposure to global (predominately U.S.) markets. The price actions of the market are a good predictor of future returns, until they are not, which is why we broaden our signal base with more fundamental factors. It is those fundamental factors that are warranting a cautious approach.
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